China Faces Overcapacity Test

A worker surveys production at a steel plant in Ganyu county, Jiangsu province, Jan. 18, 2013.

ImagineChina

If some of the economic reforms of China's new government sound familiar, that may be because previous governments have tried them before.

In July, for example, the Ministry of Industry and Information Technology (MIIT) ordered some 1,400 companies in 19 industries to stop surplus production by Sept. 30 and eliminate overcapacity by the end of the year.

The industries include some of China's biggest power users and perennial polluters, such as steel, aluminum, and cement.

On Aug. 17, the official Xinhua news agency said the order was in keeping with President Xi Jinping's policy of prioritizing cuts in overcapacity to boost industrial restructuring.

"It has been a decade since authorities began to shut down steel, cement, and electrolytic aluminum producers who were at overcapacity," Xinhua noted, adding that the number of targeted industries has grown to 19 from three in 2003.

Small impact

But a Reuters analysis on July 31 concluded that the order "underwhelms" with its impact, since it would affect less than 1 percent of production in the steel and aluminum sectors and only about 3 percent of cement.

Last year, the steel and electrolytic aluminum industries operated at 67 percent and 78 percent of capacity, Xinhua said, citing official data. The figures suggest the latest reform will have little if any effect at all.

MIIT last vowed to tackle overcapacity in 2009 as speculators and banks poured money into construction related industries.

In the first half of 2009, investment in cement plants soared 67 percent after surging over 60 percent in 2008, but only 66 percent of capacity was utilized, the official English-language China Daily said at the time.

The State Council under the previous government took a tough tone with the steel industry in 2009, calling 10 percent of its production capacity "illegitimate," the paper reported.

But the central government's attempts to curb new capacity in several industries had the opposite effect as provinces spurred more plant projects to beat the deadlines for cuts.

"Some regions have acted illegally," the State Council complained. "We are once again seeing cases of illegitimate approvals, of construction starting before it has been approved, and of construction starting even as the approval process is underway."

Meaningless promises

As a result, the overcapacity problem from the last round of reforms to the latest one has stayed largely unchanged.

The conflicting interests of Beijing, banks, and production-minded local officials will stall reform again without fundamental change, said Derek Scissors, senior research fellow in Asian studies at the Washington-based Heritage Foundation.

"The State Council's promises to curb overcapacity ... have been made for years and mean absolutely nothing," Scissors argued in an analysis.

"What would be meaningful is withdrawing regulatory protection and other subsidies at the local and national level that enable state-owned enterprises operating in the steel, aluminum and other industries to continuously supply more than the market demands," he said.

"In other words, struggling state firms must be permitted to fail," Scissors wrote.

Targeted facilities already idle

Even with their current subsidies and easy bank loans, some industries like steel may be perilously close to failing.

The iron and steel industry lost 699 million yuan (U.S. $113 million) in June, while the China Iron and Steel Association (CISA) reported a first-half industry profit margin of just 0.13 percent, Xinhua reported.

Yet, the latest order on overcapacity may have little effect because many of the targeted facilities are already idle, according to Reuters.

In an interview, Scissors said that heavy and construction-related industries have responded to previous government orders by closing down the most inefficient production, providing some energy-saving and environmental benefits.

But old facilities have been replaced with more than enough new ones.

"What they're actually doing is cutting 5 percent of excess capacity and adding 10 more percent on, so the capacity problem is actually getting worse, even while they're modernizing their facilities," Scissors said.

The argument is supported by figures on steel cited in a China Daily commentary by Zhao Xiao and Chen Jinbao, Beijing University of Science and Technology economists, on Aug. 19.

According to CISA, China reduced production capacity of crude steel by 76 million tons between 2006 and 2012, but it added 440 million tons of capacity during the same period.

The academics said that local governments had expanded enterprises to keep them from being closed down as too small, aggravating the overcapacity problem.

"What the government should do now is to create a good environment for market competition and give the market a bigger role in the distribution of resources and the national structural adjustments," they said.

A test for the reform agenda

The effort to deal with overcapacity will be a test for the new government's entire reform agenda as it pushes more sustainable development at more moderate economic growth rates.

The government has repeatedly resisted calls for another major stimulus program to restore faster growth, but local officials have yet to be persuaded.

One reason is that China's urbanization policy still has a lot of the same development implications as the old stimulus agenda that drove excessive investment in industries like cement and steel.

Despite the new government's efforts since March to cool the real estate market, property prices have continued to climb, sending a mixed signal to the construction-related industries.

In July, prices for new and existing homes rose in 62 of China's 70 major cities, the National Bureau of Statistics (NBS) reported last week.

Spending plans of the previous government for big-ticket infrastructure like rail development have also been endorsed by China's new leaders.

In 2013-2015, combined railway investment will total 2.06 trillion yuan (U.S. $336.3 billion), according to state media reports.

Even if all the funds are never spent, the targets may make industries like steel reluctant to forsake overcapacity so fast.

Unlike its predecessors, the new government will be challenged not only to announce capacity cuts but to see that they actually take place.

"They have failed miserably for years to deal with this issue," Scissors said.